Interest Rates: Judgements to get harder

Australia's Reserve Bank has reasserted its control over monetary policy locally but the rest of the world is set to dictate outcomes increasingly. Reserve Bank watchers might become less confident in their forecasting.

The Reserve Bank stumped market economists by not raising interest rates last week. It seems the economists had over analyzed recent Reserve Bank utterances about the prospects for interest rates. Sure, bank officials had mused publicly about a need for higher interest rates. That, apparently, did not imply a need for immediate action.

In recent years, the number of professional Reserve Bank followers has been growing. The consensus reports preceding central bank meetings have become almost as newsworthy as the meeting outcomes themselves. There has been a sense, at times, that analysts were deciding what should be done with officials meeting to simply validate the inevitable policy adjustment.

There is nothing especially surprising about similarly educated professionals looking at the same data and drawing the same policy conclusion. In Australia, commentators expect interest rates to move in response to changes in the momentum of consumer price inflation. Stronger growth will largely be taken to mean a more rapid closing of the output gap and a precursor to higher inflation.

To a large degree, local analysts were applying this methodology to reach their conclusions about how the Reserve Bank would act last week.

The background against which Australian interest rates are being set has grown suddenly more complicated.

A higher exchange rate, for example, will tend to reduce domestic economic activity. Lower growth due to reduced output among exporting manufacturers and rising quantities of cheaper imports will reduce the need for higher interest rates to effect a similar cut in activity.

Different cyclical positioning also makes the policy decision more complicated. If rising cyclical pressures in Australia were coinciding with similar pressures outside Australia, the decision to tighten policy in Australia would be more straightforward. Complementary settings in Australia and overseas would be self reinforcing.

Currently, monetary policy in Australia has a tightening bias while in Japan, Europe and the USA the pressures are in the other direction. Moves toward quantitative easing and reflation in these countries will also push commodity prices higher. This will promote what is being referred to as Australia's two speed economy.

Australia's policy to moderate the domestic effects of commodity price inflation is fighting against some immensely powerful forces, namely, the combined might of central banks in Europe, Japan and the USA.

Arguably, Australia's policymakers will be able to do little to force an adjustment in favor of their preferred policy outcomes against these forces. They might be able to speak publicly about their preference to effect some adjustments but do little in practice.

Pushing up interest rates to a level that will have a meaningful effect on curtailing domestic demand might put an intolerable burden on those parts of the economy that are not direct beneficiaries of global monetary conditions. There will be a point at which the costs of doing this will be too great.

One of the judgments policy analysts and policy makers will have to confront is how they reconcile these pressures. This might mean a broader dispersion in expectations among market commentators in the future.

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